Private Equity Valuation and Reporting Conference Proceedings ...
Private Equity Valuation and Reporting Conference Proceedings ...
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<strong>Private</strong> <strong>Equity</strong> <strong>Valuation</strong> <strong>and</strong> <strong>Reporting</strong> <strong>Conference</strong><br />
<strong>Proceedings</strong><br />
June 18 – 19, 2003
Table of Contents<br />
1. Introduction 3<br />
2. <strong>Conference</strong> <strong>Proceedings</strong><br />
3. Appendices<br />
Opening Remarks 8<br />
Session 1: Summary of Key Guideline Initiatives 9<br />
Session 2: The Accounting Industry 28<br />
Session 3: Implementation – The Hard Reality 38<br />
Session 4: Breakout Discussions 48<br />
A. BVCA <strong>Valuation</strong> Guidelines<br />
B. BVCA PowerPoint Presentation<br />
C. ILPA PowerPoint Presentation<br />
D. Keynote Speech<br />
Page 2 of 59
Introduction<br />
On June 17 th <strong>and</strong> 18 th of 2003, the Center for <strong>Private</strong> <strong>Equity</strong> <strong>and</strong> Entrepreneurship hosted 48<br />
private equity practitioners <strong>and</strong> recognized industry thought leaders for a conference on trends<br />
<strong>and</strong> developments in valuation <strong>and</strong> reporting in the industry. Attendees offered a wide range<br />
of experiences, with representation from the following groups:<br />
General Partners (both Venture <strong>and</strong> Buyout)<br />
Limited Partners<br />
Fund-of-Fund Managers<br />
Accountants<br />
Lawyers<br />
Consultants <strong>and</strong> Service Providers<br />
Industry Organizations<br />
Association Francaise des Investisseurs en Capital (AFIC)<br />
Association for Investment Management <strong>and</strong> Research (AIMR)<br />
British Venture Capital Association (BVCA)<br />
European <strong>Private</strong> <strong>Equity</strong> <strong>and</strong> Venture Capital Association (EVCA)<br />
Financial Accounting St<strong>and</strong>ards Board (FASB)<br />
Institutional Limited Partners Association (ILPA)<br />
National Venture Capital Association (NVCA)<br />
<strong>Private</strong> <strong>Equity</strong> Investment Guidelines Group (PEIGG)<br />
The purpose of the conference was to bring all of the groups together in one forum to discuss<br />
freely <strong>and</strong> anonymously the increasingly important <strong>and</strong> visible issue of valuation st<strong>and</strong>ards<br />
within the private equity industry. Prior to the conference, such a forum for open, face-toface<br />
discussion had not been provided to the various parties. This discussion format was<br />
important for the different participants in the industry to achieve a common underst<strong>and</strong>ing of<br />
valuation issues as a basis for possible industry consensus on valuation guidelines.<br />
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Tom Franco, Chairman <strong>and</strong> CEO of Broadgate Consultants, as keynote dinner speaker drew a<br />
parallel to the situation in the late 1980’s when the government regulation threatened the<br />
private equity industry in the wake of the leveraged buyout mania that was restructuring<br />
corporate America inside out. The industry was able to unite <strong>and</strong> effectively make the case<br />
that LBOs were good for the economy <strong>and</strong> regulation was successfully avoided. Franco<br />
concluded that a common industry approach avoided potentially harmful government<br />
regulation based on misunderst<strong>and</strong>ings. This conference was intended to foster such<br />
collaboration in the industry efforts to avoid the next wave of regulatory pressures.<br />
Many private equity practitioners agree that the status quo in private equity valuation is no<br />
longer adequate for the industry <strong>and</strong> that some form of formal st<strong>and</strong>ards or guidelines (beyond<br />
the 1990 NVCA proposed guidelines) should be created. This was confirmed by a survey<br />
conducted by the Tuck Center for <strong>Private</strong> <strong>Equity</strong> <strong>and</strong> Entrepreneurship of 368 venture <strong>and</strong><br />
buyout managers, of which 46% stated that they would like to see industry st<strong>and</strong>ards. What<br />
those st<strong>and</strong>ards comprise <strong>and</strong> who should create them are more difficult questions, which the<br />
conference helped address. The survey also showed that 51% of respondents wanted an<br />
industry association to take the lead in forming the guidelines, but the US has significantly<br />
lagged Europe in creating official st<strong>and</strong>ards for valuation. The EVCA, BVCA <strong>and</strong> AFIC<br />
were all represented at the conference <strong>and</strong> have all recently published updated guidelines for<br />
valuation. The latest BVCA guidelines were released after the conference <strong>and</strong> are attached in<br />
Appendix A. While membership in these organizations is required of private equity firms<br />
(unlike in the US), none of them actually has the right or duty to enforce the valuation<br />
st<strong>and</strong>ards, but rather they are suggested best practices.<br />
The NVCA proposed guidelines created in 1990 are currently the “de facto” guidelines for<br />
private equity valuation in the US, <strong>and</strong> they do not go into as much detail as their European<br />
counterparts. An ad hoc committee named <strong>Private</strong> <strong>Equity</strong> Investment Guideline Group<br />
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(PEIGG), which comprises representatives from both the GP <strong>and</strong> LP community, has recently<br />
taken up the challenge of developing a new set of guidelines. The committee is expected to<br />
publish its recommendations in the Fall of 2003. Additionally, the Association for Investment<br />
Management Research (AIMR) has been working to exp<strong>and</strong> its own valuation st<strong>and</strong>ards to<br />
include alternative asset classes. A problem is that each organization is working<br />
independently of the other, <strong>and</strong> the concern is that without collaboration consensus will not be<br />
reached. One view of the conference participants was the possibility that PEIGG (with<br />
greater participation from AIMR), ILPA, <strong>and</strong> the major accounting firms might work together<br />
to publish a set of US valuation guidelines. However, broadly acceptable guidelines will need<br />
to incorporate input from many parties, <strong>and</strong> it was suggested that another conference be held<br />
that would again include PEIGG, ILPA, EVCA, BVCA, NVCA <strong>and</strong> AIMR in the near term.<br />
With respect to valuation st<strong>and</strong>ards, key viewpoints began to emerge as the conference<br />
progressed:<br />
1. Guidelines will need to reflect “fair value” as defined by GAAP, <strong>and</strong> portfolio<br />
investments should be marked to market on a periodic (preferably quarterly) basis.<br />
2. Guidelines should reflect “prudence”, meaning a fair-value based approach to<br />
valuation, which is different than a cost-based approach or an approach that artificially<br />
understates value.<br />
3. The major challenges for wide acceptability <strong>and</strong> usefulness will be valuation<br />
guidelines that are seen as GAAP compliant by the accounting industry.<br />
One major issue that arose in the discussions was a byproduct of the preference for<br />
transparency <strong>and</strong> accuracy, the probable increase in volatility of interim valuations. While<br />
most participants favored moving closer to a “fair value” system of valuation, the assumed<br />
associated increase in volatility was unsettling to some participants who thought it would be<br />
misleading given the long term, illiquid nature of the asset class. In this light, an interesting<br />
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parallel to the real estate industry was drawn. The point was made that the real estate industry<br />
made the shift to quarterly mark-to-market valuations, <strong>and</strong> volatility did occur. However, this<br />
was part of the development of real estate as an asset class, <strong>and</strong> private equity should be<br />
prepared to go through similar growing pains.<br />
From the LP perspective, most representatives voiced the opinion that having one rigorous<br />
methodology for valuing portfolio companies was less important than creating more<br />
transparency in describing <strong>and</strong> explaining the methodologies <strong>and</strong> judgement used. The<br />
example of differing valuations of the same company by different GPs is often brought up in<br />
discussions for the need for st<strong>and</strong>ardized valuation principles, <strong>and</strong> GPs often bristle at this as<br />
an attempt to remove all subjective judgement from the valuation process. In contrast, the LP<br />
representation at the conference recognized that GP subjectivity was an important component<br />
of the valuation <strong>and</strong> reporting process. Most LPs did not perceive a problem with differing<br />
valuations of the same portfolio company, provided that each GP disclosed in detail the<br />
methodology <strong>and</strong> rationale used in presenting such a valuation. The point was also made that<br />
if all GPs used the same guidelines, even with subjective components, the dispersion between<br />
valuations of the same company across multiple GPs could decrease. LPs believed that<br />
objective guidelines would be an important step in improving information quality <strong>and</strong> helping<br />
them manage their portfolios more effectively.<br />
The conference participants agreed that there are two important reasons for trying to arrive at<br />
agreement on valuation st<strong>and</strong>ards: eventual international guidelines <strong>and</strong> building greater trust<br />
between GPs <strong>and</strong> LPs. As with accounting st<strong>and</strong>ards that are slowly moving toward a goal of<br />
one international accounting st<strong>and</strong>ard accepted by most if not all nations, it is important to<br />
note that international private equity valuation guidelines would greatly facilitate cross-border<br />
investing <strong>and</strong> performance comparisons.<br />
Page 6 of 59
The trust between LPs <strong>and</strong> GPs, which is vital to both parties, has been negatively affected<br />
due to the enormous amounts of money committed to the asset class <strong>and</strong> the subsequent losses<br />
in portfolio value in recent years. One of the significant issues that arose in the discussion<br />
was GP compensation <strong>and</strong> the effects that interim portfolio valuations have on carried interest<br />
<strong>and</strong> management fee payouts. This is becoming significantly more important as LPs are<br />
currently finding it difficult to enforce clawback provisions. Interestingly, the point was made<br />
that many LPs were compensated on the performance of their own assets under management,<br />
<strong>and</strong> the question was asked as to whether they were ready for the volatility of their own<br />
portfolios that a fair value approach would engender.<br />
It was broadly agreed that the benefits to rebuilding the GP-LP trust reach beyond mere<br />
harmony in the private equity industry. This trust is critical to capital formation <strong>and</strong><br />
investment in innovation <strong>and</strong> growth, <strong>and</strong> this is the foundation of a strong private equity<br />
sector of the economy.<br />
The Tuck Center for <strong>Private</strong> <strong>Equity</strong> <strong>and</strong> Entrepreneurship gratefully acknowledges the<br />
participation of the following individuals in preparing these proceedings: Colin Blaydon,<br />
Fred Wainwright, Jeffrey Paré, Jane Penner, Theresa Sorrentino, <strong>and</strong> Gail Sweeney.<br />
Page 7 of 59
<strong>Conference</strong> <strong>Proceedings</strong><br />
Opening Remarks<br />
Colin Blaydon, Director of the Center for <strong>Private</strong> <strong>Equity</strong> <strong>and</strong> Entrepreneurship, began by<br />
stating the goal of the conference: to bring together people who have been working on <strong>and</strong><br />
talking about private equity valuation <strong>and</strong> reporting issues <strong>and</strong> to share the resulting wisdom<br />
with the wider world. Professor Blaydon went on to note the variety of players participating in<br />
the conference, including representatives from several industry groups, general partners,<br />
limited partners, <strong>and</strong> a voice speaking from the accounting oversight perspective. Finally,<br />
Professor Blaydon emphasized the quickly changing paradigms of the private equity world,<br />
<strong>and</strong> suggested that the conference could help shape these changes <strong>and</strong> help the industry<br />
determine how best to move forward.<br />
Page 8 of 59
Moderator:<br />
Session 1 : Summary of Key Guideline Initiatives<br />
Professor Colin Blaydon, Center for <strong>Private</strong> <strong>Equity</strong> <strong>and</strong> Entrepreneurship<br />
Official Speakers:<br />
1. Representative from the British Venture Capital Association (BVCA)<br />
2. Representative from the <strong>Private</strong> <strong>Equity</strong> Investment Guidelines Group (PEIGG)<br />
3. Representative from Institutional Limited Partners Association (ILPA)<br />
Impromptu Speakers:<br />
1. Representative from the Association of Investment Management <strong>and</strong> Research (AIMR)<br />
2. Representative from the Association Francaise des Investissuers en Capital (AFIC)<br />
[After introducing the speakers, Professor Blaydon noted that there is one other group at<br />
work on valuation guidelines: the American Institute of Certified Public Accountants<br />
(AICPA). Its task force was meeting in Seattle on the same day as this conference, so<br />
unfortunately no one could be at this session to give a progress report.]<br />
BVCA Presentation:<br />
The BVCA speaker introduced himself as an executive from a publicly listed private equity<br />
firm. He was a member of the “consideration committee” which produced the BVCA<br />
valuation guidelines. The speaker went on to explore several topics in a Power Point<br />
presentation (see Appendix B)<br />
He began by outlining the BVCA guidelines project timeline. Beginning to end, the process of<br />
creating guidelines took 18 months. The initial consultation phase began in December 2001<br />
<strong>and</strong> continued through March 2002. At that point, the consideration committee was formed to<br />
discuss the issues raised during consultation. An exposure draft of valuation guidelines was<br />
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issued in November 2002. After soliciting <strong>and</strong> reviewing comments on that draft, the BVCA<br />
council formally approved the guidelines in June 2003. The committee is now considering<br />
responses to the published guidelines. The speaker noted that the guidelines would be<br />
published online within a week or so of the conference.<br />
The BVCA speaker continued by discussing the relevant background of the guideline project,<br />
emphasizing two areas in particular: environment <strong>and</strong> diversity of views. The following<br />
environmental factors shaped the committee's project:<br />
• Increased regulatory influence on the private equity sector. In the UK, all private<br />
equity firms are required to be registered <strong>and</strong> authorized.<br />
• Increased publication of fund performance statistics under freedom of information<br />
laws in the U.S. Such statistics need to be arrived at using comparable <strong>and</strong> consistent<br />
methods.<br />
• Developments in financial reporting (GAAP). Firms have obligations to report in<br />
accordance with GAAP. There has been a shift within GAAP in favor of principlesbased<br />
rather than rule-based st<strong>and</strong>ards; <strong>and</strong> GAAP has moved away from cost-based<br />
measures towards value-based measures.<br />
• Increasing dem<strong>and</strong> for reliable, realistic information (driven, of course, by poor<br />
performance in recent years).<br />
• Increasing secondary activity. <strong>Private</strong> equity investors were originally tied in for up to<br />
10 years, so interim valuations were less important, but now there are an increasing<br />
number of liquidity options available.<br />
• Overall attempt to assess what private equity investors expect <strong>and</strong> need -- especially<br />
investors who are new to the equity class. In general, investors want to be able to<br />
Page 10 of 59
assess their asset allocation positions as <strong>and</strong> when they wish <strong>and</strong> to compare<br />
performance across investment managers <strong>and</strong> funds.<br />
Several conflicting views about valuation <strong>and</strong> reporting currently inform the private equity<br />
industry <strong>and</strong> make the process of coming up with common guidelines very challenging. The<br />
BVCA rep described how industry players often lock horns over the following issues:<br />
• Prudent valuations ("conservative" valuations designed to avoid unpleasant surprises)<br />
versus realistic valuations (those that depict a true picture of the<br />
progress/performance).<br />
• "Smoothed" results (the use of prudent or conservative valuation methods can serve to<br />
enhance the non-correlation benefit of private equity) versus more volatile results<br />
(those that reflect realistic values).<br />
• Whether full disclosure ("transparency") is sufficient on its own. Said another way:<br />
Should GPs provide full information <strong>and</strong> let the LPs sort through it on their own? In<br />
that case, it is argued, there would be no need for guidelines. Yet even in a "full<br />
disclosure" scenario, the LPs won’t get comparability <strong>and</strong> consistency, nor the benefit<br />
of the GP’s judgment in estimating values.<br />
• St<strong>and</strong>ardization (of valuation <strong>and</strong> reporting) is a good idea versus st<strong>and</strong>ardization is a<br />
bad idea.<br />
• Mechanistic/formulaic approach versus judgmental/qualitative approach. Said another<br />
way: Are GPs best positioned to determine value using subjective analysis or are they<br />
(as self-interested parties) inherently untrustworthy?<br />
• Within private equity, it is possible in practice to derive reliable, up-to-date valuations<br />
versus it is impossible in practice to derive reliable, up-to-date valuations.<br />
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After presenting the background informing the committee's deliberations on valuation <strong>and</strong><br />
reporting guidelines, the BVCA rep described the committee's agreed-upon goals. In their<br />
view, valuation guidelines must:<br />
• Clearly specify the overriding basis of valuation – i.e. what exactly the carrying<br />
amount purports to represent.<br />
• Privilege GP’s judgment above prescription. In other words, valuations should not be<br />
derived from a predetermined formula. GPs, using good-faith efforts, should be able to<br />
come to a fair value.<br />
• Use tight language, in order that compliance with the guidelines can be objectively<br />
assessed. “Should” statements <strong>and</strong> other qualitative language must be used, so as to<br />
not override GPs' judgments.<br />
• Promote comparability of performance – one year with another, one fund with<br />
another, <strong>and</strong> one fund with another asset class. This could only be achieved by using<br />
realistic values, rather than prudent (“conservative”) values.<br />
• Be GAAP-compliant.<br />
• Avoid procedural or corporate governance issues, such as the frequency <strong>and</strong> timing of<br />
valuations, or whether they should be audited.<br />
The BVCA speaker went on to summarize the key points of the guidelines developed by the<br />
committee.<br />
• The use of “fair value” as the overriding basis of valuation. Fair value is defined for<br />
the purposes of the guidelines precisely as it is for the accounting industry in IAS 39,<br />
“the amount for which an asset could be exchanged between knowledgeable, willing<br />
parties in an arm’s length transaction.”<br />
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• When valuing start-up <strong>and</strong> early stage investments, the committee recognized that fair<br />
value may not be capable of reliable measurement – where this is the case, the<br />
recommendation is to use the latest carrying value less any impairment.<br />
• Discounts used should relate solely to marketability (i.e. is there to reflect the<br />
economic reality that the fund cannot cash in its investment immediately). The<br />
committee also acknowledged that marketability circumstances varied, <strong>and</strong> the amount<br />
of discount applied should therefore also vary. A majority holding is probably more<br />
marketable than a minority stake.<br />
• Discounts from market prices should be permitted for quoted investments.<br />
Regarding unquoted investments, the BVCA guidelines identify a number of methodologies<br />
<strong>and</strong> distinguish between primary <strong>and</strong> secondary valuation methods. Primary methods should<br />
be used unless they are demonstrably inappropriate, in which case secondary methods should<br />
be used. Primary valuation methods, according to BVCA guidelines, include the following:<br />
earnings multiple, price of recent investment <strong>and</strong> net assets. Secondary valuation methods<br />
include: discounted cash flows or earnings of underlying business, discounted cash flows<br />
from the investment (this can be a primary valuation method where realization or flotation is<br />
imminent) <strong>and</strong> industry valuation benchmarks. The speaker noted that the valuation methods<br />
for unquoted investments outlined in the BVCA guidelines are by no means comprehensive.<br />
In conclusion, the BVCA speaker observed that developing guidelines had been a long<br />
process, involving a lot of consultation. Overall, the BVCA guidelines reflect the primacy of<br />
the GPs’ judgment <strong>and</strong> realistic values over the use of prescriptive guidance <strong>and</strong> prudent<br />
values. Of course, implementation in real-life situations will be the true test of any<br />
guidelines, including the BVCA's. Finally, the speaker emphasized that international<br />
harmonization in this area is an important long-term goal <strong>and</strong> one which the BVCA wished to<br />
support.<br />
Page 13 of 59
Q&A Session<br />
The first question followed up on the BCVA speaker's mention of providing complete<br />
disclosure of all information about holdings in lieu of guidelines. He asked where that<br />
conversation led. The BVCA rep responded that the committee ultimately decided that the<br />
degree of transparency on holdings information was a reporting issue rather than a valuation<br />
issue. Separate guidelines should be created <strong>and</strong> followed for reporting. The next question<br />
inquired whether British firms are required to be BVCA members <strong>and</strong> whether members are<br />
required to follow the BVCA guidelines. The BVCA rep responded that all PE firms are<br />
required to be in the BVCA, but the guidelines are only there for guidance. They are not<br />
required, <strong>and</strong> are not enforceable.<br />
PEIGG Presentation:<br />
The speaker began by commenting that PEIGG is a much younger organization than the<br />
BVCA, <strong>and</strong> subsequently is much earlier on in the process of creating guidelines. PEIGG was<br />
formed in the early part of 2002 from a group of 20 practitioners in the private equity<br />
business. It has established a number of committees on reporting PE investments to investors<br />
<strong>and</strong> has one sub-committee focused on valuation issues. That sub-committee consists of two<br />
LPs <strong>and</strong> two GPs, percentages that reflect the overall composition of PEIGG. It was set up<br />
that way in order to be able to arrive at a consensus that is in harmony with the views of the<br />
private equity industry as a whole.<br />
When evaluating the prevailing philosophies about determining valuation, the valuation subcommittee<br />
decided that, if guidelines were to err, they should err on the on the conservative<br />
side. The PEIGG sub-committee wants to prevent one-time events from skewing valuations<br />
to any large degree. It also wants LPs involved <strong>and</strong> thinks reporting should be transparent,<br />
but feels that the GPs are responsible for the numbers at the end of the day. The sub-<br />
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committee reviewed the EVCA <strong>and</strong> the BVCA guidelines <strong>and</strong> drafted a proposal, which they<br />
then circulated within the whole PEIGG. After repeating this process<br />
(proposal/consultation/revision) several times, an initial draft of PEIGG valuation guidelines<br />
was created in April 2003 (this draft appears attached as an appendix to this report). The subcommittee<br />
is in the process of soliciting feedback (with the help of KPMG <strong>and</strong> a data matrix);<br />
a final draft of the guidelines is expected to appear in fall 2003. PEIGG has no authority to<br />
enforce the guidelines, but the speaker expressed the hope that associations <strong>and</strong> firms will<br />
adopt the PEIGG recommendations as “best practices.”<br />
Q&A Session<br />
The first question addressed the impact of PEIGG's recommendations on secondary sales:<br />
does a conservative ("no surprises") approach wind up undervaluing the assets of secondary<br />
sellers? The PEIGG representative responded that this issue had come up in the committee<br />
<strong>and</strong> been discussed at length. PEIGG's position is that secondary sales should have no effect<br />
on valuation, because most secondary sellers are distressed, trying to get out of future<br />
commitments they can't or don't want to cover. In such situations, the seller should still go<br />
through a valuation process for their own benefit in order to calculate a more accurate value<br />
than their selling price. But no buyer should then use that value to determine a price for the<br />
position. A follow-up question asked how secondary funds buying the same positions from<br />
different sellers at different values should reflect such purchases on their books. The PEIGG<br />
representative suggested that funds in that position initially record the value of the positions at<br />
cost <strong>and</strong> then write up the positions to fair value over the course of the year. In such cases, he<br />
added, secondary funds must factor in why the seller is selling. The final question addressed<br />
whether the PEIGG guidelines are GAAP-compliant. The speaker responded that there is one<br />
major discontinuity between PEIGG guidelines <strong>and</strong> GAAP, because GAAP allows no<br />
discounting for liquidity of blocks of public securities held by a fund <strong>and</strong> PEIGG disagrees<br />
with that position. The speaker noted that there will be major discussions about this issue in<br />
the future, since GPs don't want to keep two set of books -- one GAAP-compliant <strong>and</strong> one<br />
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eflecting "true value." [Editors’ note: in a subsequent PEIGG meeting, the group decided to<br />
follow GAAP <strong>and</strong> not require a discount.]<br />
AIMR Presentation (Impromptu):<br />
An AIMR representative began by acknowledging two other conference participants who<br />
were on AIMR's private equity valuation task force. Giving a little background for those<br />
unfamiliar with AIMR (an investor advocate organization) he explained that AIMR's effort to<br />
develop performance presentation st<strong>and</strong>ards (for stocks <strong>and</strong> bond funds, as well as for events<br />
such as presentations to institutional investors or “road shows”) is exp<strong>and</strong>ing to cover other<br />
asset classes, including private equity in general <strong>and</strong> private equity valuation in particular. He<br />
emphasized that AIMR is a global organization (unlike most of the other groups developing<br />
guidelines) <strong>and</strong> therefore is in a good position to marshal consensus on valuation st<strong>and</strong>ards.<br />
The task force hopes to develop guidelines that will be embraced by many (if not all) industry<br />
constituents <strong>and</strong> which can be applied globally. He also said that the AIMR guidelines are<br />
ideally aimed at helping orient those investors who are new to the private equity asset class.<br />
Regarding how the AIMR guidelines might develop, the representative said that the task force<br />
recommends fair value methods (as opposed to conservative methods) for PE portfolio<br />
valuation. He also expressed the opinion that, in today’s world, most parties agree that fair<br />
value is the best method -- this consensus didn't always exist. Finally, he noted that, in<br />
coming up with guidelines, the task force focused on "high-level principles" <strong>and</strong> common<br />
sector principles rather than details or specifics. Discussing AIMR's timeline, the<br />
representative said that the task force produced an exposure draft of guidelines last summer<br />
(released in the fall) <strong>and</strong> is now incorporating comments for a final proposal to be presented<br />
to the governing council in September 2003.<br />
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AFIC Presentation (Impromptu)<br />
A conference participant was asked to speak about the development of AFIC guidelines (the<br />
guidelines are included in the conference binder). The speaker identified herself as a general<br />
partner <strong>and</strong> CFO of a French venture capital firm, as well as a member of the EVCA <strong>and</strong> the<br />
head of the AFIC valuation task force. The speaker began by saying that, when EVCA<br />
guidelines were published in March 2001, the initial effort was merely to translate them into<br />
French. However, during the translation process, AFIC members realized that the guidelines<br />
needed to be reworked <strong>and</strong> updated. According to the speaker, the French guidelines are still<br />
heavily based on the EVCA’s, but there are some important differences. Namely, the French<br />
guidelines give general partners more flexibility than do the EVCA guidelines. AFIC's<br />
position is that any <strong>and</strong> all rules governing valuation must be fully described in partnership<br />
agreements. That way, LPs (or auditors) can easily determine if GPs are complying with what<br />
was agreed upon.<br />
Speaking more generally about the European environment, the AFIC representative observed<br />
that the private equity industry in Europe has been motivated to self-regulate in a way that the<br />
U.S. private equity industry has not (yet) been. As a result, the European industry<br />
associations are working together much more closely than ever before. In response to a<br />
question, the speaker noted that, while all French companies have to be registered with AFIC,<br />
the organization's guidelines <strong>and</strong> recommendations are not enforceable.<br />
ILPA Presentation:<br />
The speaker introduced himself as a managing director responsible for the corporate equity<br />
portfolio at a large insurance company. He began the presentation by giving some<br />
background information on ILPA, noting that it is the only organization dedicated to the<br />
interests of institutional LPs in private equity. There are 150 member firms, with a large<br />
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international representation. The majority of ILPA's members are large investors, <strong>and</strong>,<br />
together, they represent about two-thirds of the total allocations in the global private equity<br />
industry (smaller players who are ILPA members represent a smaller percentage of PE<br />
allocations). Furthermore, 80% of all investors with $1 billion under management are<br />
members.<br />
ILPA members meet two times a year for three days. Its mission is to facilitate<br />
communication, <strong>and</strong> (to that end) the organization has just appointed its first-ever executive<br />
director. Networking, education <strong>and</strong> information sharing are very important goals. There are<br />
three committees within ILPA focused on best practices: reporting, valuation <strong>and</strong><br />
performance measurement. <strong>Valuation</strong> issues in particular have been a core topic of discussion<br />
during the last two meetings. The ILPA speaker emphasized two caveats about his remarks: 1)<br />
the beliefs expressed are majority opinions (unanimity among 150 members is virtually<br />
impossible); <strong>and</strong>, 2) the beliefs expressed are ILPA's recommendations for best practices (i.e.<br />
they are NOT attempting to provide guidelines or st<strong>and</strong>ards).<br />
The rest of the speaker's comments were divided into two sections: ILPA's response to the<br />
PEIGG guidelines <strong>and</strong> ILPA's response to the BVCA guidelines. What follows is a summary<br />
of the discussion outlined in the speaker's presentation (see Appendix C).<br />
ILPA's Response to PEIGG Guidelines<br />
The speaker began by saying that the majority of ILPA members take issue with PEIGG's<br />
assertion that investment cost ("cost") is an adequate proxy of fair value. He listed several<br />
reasons for this position, including the following: U.S. GAAP requires fair value (rather than<br />
cost) reporting; banks <strong>and</strong> insurance companies are required to "mark to market;" <strong>and</strong> many<br />
state pension plans have adopted fair value accounting. Instead of valuations based on cost (or<br />
impaired value), the majority of ILPA members favor accounting of valuations at fair value<br />
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estimated in a conservative manner (i.e. substantially greater evidence is required to write up<br />
the carrying value of investments than to write down those investments). The majority of<br />
ILPA members also feel that fair market values should be prepared quarterly, since quarterly<br />
reporting is required of LPs by GAAP (PEIGG guidelines are not specific about how often<br />
GPs should report valuations to LPs.)<br />
Addressing PEIGG's criteria for write-ups <strong>and</strong> write downs, the speaker noted that the<br />
majority of ILPA members would like to see more symmetry between the criteria for writeups<br />
<strong>and</strong> the criteria for writedowns. While writeups at venture funds should require objective<br />
(transactional) evidence, writeups at buyout funds may credibly be based upon improved<br />
financial performance <strong>and</strong>/or market multiple expansion in addition to transactions.<br />
Additionally, ILPA members generally feel that writedowns at both buyout funds <strong>and</strong> venture<br />
funds should (following a conservatively implemented fair value approach to valuation) be<br />
based on subjective as well as objective criteria.<br />
The ILPA speaker went on to discuss financial statements in light of the PEIGG guidelines.<br />
He began by reiterating that the majority of ILPA members feel that carrying value should be<br />
fair value, as required by U.S. GAAP. More generally, he expressed ILPA members' desire<br />
for an "industry-st<strong>and</strong>ard" valuation framework that would support specific fund policies <strong>and</strong><br />
processes. The guidelines describing this framework should be written in careful, specific <strong>and</strong><br />
articulate language, which, in turn, would become idiomatic within the industry. The<br />
framework should not be regulated (by external forces or professional valuators) nor should<br />
LPs expect the st<strong>and</strong>ard to magically produce completely consistent values. But such a<br />
st<strong>and</strong>ard would, if adhered to (even with predictable exceptions) by all PE firms, permit<br />
intelligible comparisons between different valuations of the same portfolio companies by<br />
different funds.<br />
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The next issue raised by the ILPA speaker dealt with the desirability of international valuation<br />
st<strong>and</strong>ards (as opposed to country-specific st<strong>and</strong>ards). Noting that there are common investors<br />
across all geographic regions as well as the fact that EVCA <strong>and</strong> BVCA guidelines are<br />
converging, the speaker said that the majority of ILPA members support U.S. private equity<br />
firms adopting European or British guidelines. Given that the U.S. lags the rest of the world in<br />
adopting valuation guidelines, the development of independent U.S. st<strong>and</strong>ards would also be<br />
viewed as a good first step (barring U.S. firms' embrace of international guidelines).<br />
The next topic concerned who should be responsible for determining valuations <strong>and</strong> valuation<br />
policy. The majority of ILPA members feel that GPs are best positioned to determine<br />
valuations (the PEIGG guidelines suggest that, in certain circumstances, formula- or rulesbased<br />
valuations are appropriate). External validation of GPs' valuations is not needed. LPs<br />
should always be informed of a fund's valuation policies, <strong>and</strong> an advisory committee (with LP<br />
members) should review <strong>and</strong> discuss -- but not ultimately approve -- those policies.<br />
Finally, the ILPA speaker addressed the potential usefulness of industry-driven guidance<br />
about valuation methods. The majority of ILPA members feel that clear guidance is preferable<br />
to rules or formulae. Specifically, they think that PEIGG guidelines, in their initial draft,<br />
while a great first step, are too broad. Clarification <strong>and</strong>/or specific examples are very helpful<br />
in all industry-driven efforts to develop valuation guidelines.<br />
ILPA’s Response to BVCA Guidelines<br />
The speaker began by outlining the exp<strong>and</strong>ed scope ILPA members would like to see the<br />
BVCA (or any) guidelines have. In addition to offering guidelines on investor reports, they<br />
would also like to see guidelines regarding capital calls, distribution notices <strong>and</strong> capital<br />
accounts.<br />
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Regarding the basis of valuation, the majority of ILPA members feel that fair value is the best<br />
method even though a minority are comfortable with lower of cost or impaired value. There is<br />
almost unanimous support amongst the membership for a conservative estimation of fair<br />
value, with write ups for private companies being taken only when there is clear evidence to<br />
support them, <strong>and</strong> write downs being justifiable in cases of material or significant impairment<br />
of value, not just permanent impairment. Furthermore, a majority of members believes that<br />
U.S. GAAP requires fair values.<br />
The speaker noted that ILPA members are in general agreement with the BVCA's distinction<br />
between "primary" <strong>and</strong> "secondary" valuation methodologies. However, given that the<br />
valuation techniques assume that businesses are a "going concern," many members argue that<br />
"net assets" should be categorized as a "secondary" methodology; other members consider an<br />
assessment of the discounted cash flows of the underlying business to be a "primary" method<br />
of determining value.<br />
ILPA members generally approve of a marketability discount for unquoted investments <strong>and</strong><br />
thus are in agreement with BVCA guidelines on that subject. This is consistent with ILPA's<br />
majority view that methodologies employed to estimate fair value should be applied<br />
conservatively. Additionally, the speaker noted that that discounts should be applied to the<br />
equity value, not the enterprise value <strong>and</strong> that (generally speaking) businesses where cash<br />
flows have increased relative to leverage should not be carried below cost due to discounts.<br />
Wrapping up his comments on BVCA valuation guidelines, the speaker said that ILPA<br />
members generally agree that more transparency in valuation is better than less <strong>and</strong> that more<br />
frequent (ideally quarterly) valuations are better than less frequent ones. Additionally he noted<br />
members' feeling that BVCA shouldn't shy away from billing its guidelines as "best practices"<br />
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for process, practice <strong>and</strong> procedure within the private equity industry. In particular, he noted<br />
the need for the BVCA to take a stronger st<strong>and</strong> endorsing the fair value accounting practices.<br />
The speaker went on to discuss ILPA's response to BVCA's reporting guidelines. While the<br />
organization's recommendations are very similar to BVCA's, he noted some differences,<br />
including the following:<br />
• ILPA recommends that GPs prepare interim reports on a quarterly rather than a semi-<br />
annual basis;<br />
• ILPA recommends that interim reports be produced within 60 days of the end of<br />
quarter (within 90 days for Fund of Funds) <strong>and</strong> that annual reports be produced within<br />
90 days after year-end (within 120 days for Fund of Funds);<br />
• ILPA recommends that complete unaudited financial statements with footnotes be<br />
included in interim reports <strong>and</strong> complete audited financial statements with footnotes<br />
be included in annual reports;<br />
• ILPA recommends that interim <strong>and</strong> annual financial statements include footnote<br />
disclosure of any guarantees made by the partnership on behalf of the investments,<br />
including debt guarantees <strong>and</strong> contingent liabilities;<br />
• ILPA recommends that interim <strong>and</strong> annual financial statements include a note<br />
regarding the value of unrealized investments that details the carrying value <strong>and</strong> the<br />
cost basis of each investment;<br />
• ILPA recommends disclosure of any leverage to the fund, including debt <strong>and</strong><br />
guarantees, charges, or contingent liabilities.<br />
Finally, the speaker had a few comments about possible guidelines for capital calls <strong>and</strong><br />
distribution notices (BVCA guidelines do not address these subjects). In general, ILPA<br />
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members would like guidelines to recommend that GPs explain to investors what the capital<br />
call is for. Regarding distribution notices, ILPA members would like guidelines to<br />
recommend that GPs tell investors:<br />
• The amount of the return of capital;<br />
• The amount of gain or loss;<br />
• From where the distribution is coming.<br />
The speaker remarked that addressing the above issues would save GPs <strong>and</strong> LPs a lot of time<br />
<strong>and</strong> aggravation.<br />
Q&A Session<br />
Professor Michael Horvath began by observing that there seemed to be a unanimous position<br />
within ILPA regarding conservatism, <strong>and</strong> wondered aloud why everyone is so concerned<br />
about negative surprises in private assets, when such surprises are so common in public<br />
assets? He observed that investors shouldn't expect to avoid negative surprises if they seek<br />
the opportunity that exists in private equities <strong>and</strong> again raised the issue of whether a<br />
conservative approach winds up undervaluing the asset class as a whole. The ILPA speaker<br />
responded that the organization's stance is really that, since no one knows exact value (GPs<br />
are really guessing at the end of the day), values should be at the bottom (conservative) end of<br />
the possible range rather than at the top end of that range. (He distinguished this br<strong>and</strong> of fair<br />
value-based conservatism from the cost-based conservatism advocated by PEIGG <strong>and</strong> others.)<br />
The PEIGG speaker added that a cost-based conservative approach, combined with the use of<br />
milestones, reduces the likelihood of clawbacks.<br />
Professor Horvath stated that given that GPs are generally optimistic, <strong>and</strong> are also afraid to<br />
put anything in their statements that smacks of a value judgment, he asked the group why LPs<br />
<strong>and</strong>/or GPs don't simply hire third party, independent valuators to make rational economic<br />
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determinations? There seems to be a large opportunity for consultants here, especially since,<br />
under Sarbanes-Oxley, auditors need to be independent. Furthermore if third-party valuators<br />
were to start keeping track of how good funds are at reporting (calculating interim valuations,<br />
etc.), it might provide an incentive for st<strong>and</strong>ardization. This would also allow the various<br />
valuation methods (cost vs. fair value) to be intelligently compared. GPs currently have all<br />
of the data necessary to make this sort of st<strong>and</strong>ard post mortem analysis of funds possible.<br />
Some questions were raised at this point about whether an increased focus on<br />
valuation/reporting (either by GPs or by third party valuators) might encourage lawsuits. One<br />
participant observed that no valuation methods have precision to within a factor of five, even.<br />
The values are thus "highly metaphysical" -- could stoking the desire for more accurate<br />
values lead to lawsuits? Another participant opined that there is very little risk of this, due to<br />
the time <strong>and</strong> cost required to go over individual valuation estimates.<br />
Getting back to the possible st<strong>and</strong>ardization of valuation methods in private equity, one<br />
participant observed that the real estate industry is about 10 to 15 years ahead of the PE<br />
industry in thinking through these issues. As the real estate industry became increasingly<br />
institutionalized, it adopted industry st<strong>and</strong>ards for annual third party appraisals. This created<br />
quite a bit of volatility, because until an asset was sold, there was no real way of knowing<br />
what the building was worth. The debate over valuation methods in PE is just one of many<br />
signs of the industry's growing pains. The PEIGG speaker responded by noting a big<br />
difference between the real estate industry <strong>and</strong> PE, namely that real estate assets can be<br />
valued in a somewhat formulaic way (because they all have certain things in common)<br />
whereas early-stage companies cannot be. That said, however, he acknowledged that the<br />
concept of defining a set of variables to assess value could be done in the private equity<br />
industry as well <strong>and</strong> concluded that the trend seems inevitable. A representative from AIMR<br />
agreed that real estate information st<strong>and</strong>ards (RISA) are very formulaic, <strong>and</strong> noted there is an<br />
AIMR committee for real estate as well. He also commented that, within the real estate<br />
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industry, there is a lot of pressure to go back to having third party valuations done every 36<br />
months, as opposed to yearly, in order to tame volatility.<br />
At this point, the discussion returned to the debate over the meaning of "fair value." The<br />
BVCA speaker told the group that that his organization had debated the idea at length <strong>and</strong><br />
determined that "fair value is incompatible with conservatism." He characterized<br />
conservatism as a way of telling not the truth, but rather a "protected truth." Other conference<br />
participants weighed in on the subject. One suggested that a fund manager should ask himself<br />
what he would pay to "jump back into" a given position all over again -- the answer to that<br />
question would be a good indicator of the position's fair value. Another participant suggested<br />
that fair value is the price for which one could auction off one's stake, <strong>and</strong> observed that very<br />
often the price you pay for a position is not what you expect to sell it for. Another participant<br />
(a senior partner at large fund of funds) opined that, rather than wrestling with accounting<br />
definitions of fair value, industry players should be thinking, “What is a fair value for us?”<br />
The speaker noted that the answer to this question must include a mix of quantitative <strong>and</strong><br />
qualitative elements to earn any sort of credibility, <strong>and</strong> concluded that if industry players can't<br />
agree on a definition, regulators will take it upon themselves to do so.<br />
Several participants discussed the ways in which the notion of fair value becomes even more<br />
complicated in secondary fund accounting. One reminded the group that assets in secondary<br />
sales are often distressed <strong>and</strong> that one must factor in the reasons why they are distressed. He<br />
asked: "Is fair market price the last price at which they cleared? Remember, in secondary<br />
markets you are not just buying the equity position; you are buying future commitments as<br />
well. You need to consider those obligations when assessing a fair value." Another participant<br />
raised the issue of when the buyer of a distressed asset in a secondary sale can mark up that<br />
position. In response, another participant argued that a buyer in that situation could credibly<br />
mark up the position the day following the sale because the buyer has the intent <strong>and</strong> ability to<br />
hold onto that asset, unlike the seller.<br />
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A managing director at an accounting firm raised the important distinction between carrying<br />
value <strong>and</strong> realization value in the whole "fair value" debate. He recounted working with a<br />
buyout fund that did quarterly valuations, <strong>and</strong> noted that the fund's volatility was enormous.<br />
It took a huge time commitment on the part of that fund to produce those quarterly valuations.<br />
Eventually, producing the valuations became so burdensome that client said, "Forget these<br />
valuations -- just go <strong>and</strong> run the money!" The lesson? For whom are fund managers going<br />
through the exercise of portfolio valuation? Is it an efficient use of time <strong>and</strong> resources?<br />
Professor Colin Blaydon then posed a version of this question to the entire group: From where<br />
is the impetus for guidelines coming? What's the driving motivation behind that impetus?<br />
The BVCA speaker responded that his organization's motivation was to protect <strong>and</strong> benefit its<br />
members. He said that there is a fear among members of being attacked by LPs <strong>and</strong>/or the<br />
FSA. A partner at a major national accounting firm observed that trust between GPs <strong>and</strong> LPs<br />
has eroded considerably over the past decade due to more entrants in the equity class (<strong>and</strong><br />
subsequently more money under management) <strong>and</strong> because of the bursting of the Internet<br />
bubble. He posed a basic question for the group: Why do valuations even matter? Another<br />
participant responded, saying valuations often determine who gets paid what, <strong>and</strong> when --<br />
especially if there is some sort of a bonus program, benchmark, or job performance st<strong>and</strong>ard<br />
in place. Furthermore, he argued, there is a perception, if not a reality, that valuations matter<br />
because of a fundamental misalignment of interests between LPs <strong>and</strong> GPs. If we can fix the<br />
misalignment, he argued, a lot of the tension would be resolved.<br />
The managing general partner of a large VC fund weighed in on this issue, noting that<br />
discussions with LPs get a lot calmer when they realize that the GPs' compensation never<br />
derives from interim valuations. But, he noted, the LPs are still very interested in interim<br />
valuations all the same. He went on to emphasize the importance of underst<strong>and</strong>ing the LP/GP<br />
relationship as a partnership. Ideally, both parties should be continually imagining what it's<br />
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like to be in the other’s shoes. He went on to argue that any sort of institutionalization of the<br />
LP/GP relationship jeopardizes the quality of that partnership. LPs <strong>and</strong> GPs must have<br />
mutual trust <strong>and</strong> must be communicating with each other; a report just won’t cut it.<br />
Furthermore, he argued that most GPs don't have the time to really underst<strong>and</strong> the<br />
increasingly "transparent" information that they’re getting ("That's the stuff they are paying us<br />
to interpret!") In the end, a compatible LP structure (partnership agreement) will serve all<br />
parties better than complete transparency. For the business to work, it has to revolve around<br />
trust. He went on to suggest that a lot of the pressure (i.e. lack of trust) is coming from new<br />
entrants who approach venture capital with a transactional attitude, which is inappropriate.<br />
Venture capital, in particular, is a building business -- if you haven’t been around long enough<br />
to see year 12, then you really haven’t lived through a cycle. He concluded by saying that now<br />
is the time to solve this contentious issue of valuation, because so little money is being raised<br />
right now. In 18 months or two years, it will be a very different world to be seen out there<br />
<strong>and</strong> the conversation will be that much more fraught.<br />
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Moderator:<br />
Session 2 : The Accounting Industry<br />
Professor Rick Antle, Yale School of Management<br />
Official Speakers:<br />
1. Representative from FASB<br />
2. Representative from a major national accounting firm<br />
3. Representative from a major national accounting firm<br />
Speaker #1<br />
After thanking the Center for the opportunity to speak, the FASB speaker read a disclaimer<br />
<strong>and</strong> informed the group that this disclaimer applied to any remark that the speaker made at<br />
any time during the conference. The speaker began by giving an overview of the five topics to<br />
be covered:<br />
• FASB's definition of fair value for financial reporting;<br />
• Application of the fair value measurement attribute in U.S. GAAP;<br />
• FASB criteria for decision making, applied to fair value measurements;<br />
• Current FASB thinking about fair value measurements, with specific attention paid to<br />
applications to private equity scenarios (the speaker developed these scenarios from<br />
reading the BVCA document);<br />
• Current FASB fair value measurement project.<br />
FASB's tentative definition of fair value is as follows: "the amount at which an asset or<br />
liability could be exchanged (or settled) in a current transaction between knowledgeable,<br />
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unrelated, willing parties when neither is acting under compulsion." The speaker noted that<br />
the definition is "tentative" until it is published in official FASB public documents. The<br />
speaker also clarified several terms used in the definition, noting "current transaction" means<br />
close in time, <strong>and</strong> that Statement 57 of GAAP provides a definition of "related parties."<br />
Regarding "compulsion," the speaker stated that such compulsion could be economic (i.e. a<br />
distressed sale) <strong>and</strong> therefore wouldn't be recognized as fair value. Finally, the speaker<br />
pointed out that FASB’s definition doesn’t require a real marketplace; the objective is to<br />
estimate the single exchange price at which hypothetical willing marketplace participants<br />
would agree to transact, excluding transaction costs.<br />
The speaker went on to discuss the applicability of fair value measurements in U.S. GAAP,<br />
stating that US GAAP requires fair values in some but not all current <strong>and</strong> proposed st<strong>and</strong>ards.<br />
GAAP requires fair value measurements for certain assets <strong>and</strong> liabilities acquired in a<br />
business transaction; for impaired assets (including purchased goodwill); for certain<br />
derivatives; for certain performance obligations (guarantees, per FIN 45); <strong>and</strong> for some<br />
financial instruments (per FAS 115). Despite the fact that there are a few st<strong>and</strong>ards that<br />
require present value measures (as opposed to fair value), the trend is toward fair value<br />
measures; ideally, FASB would like one way to think about this issue.<br />
The speaker's next topic was FASB's criteria for decision-making. Following the Conceptual<br />
Framework, reported information should be:<br />
• Relevant: capable of affecting decisions. (Fair values are sometimes the only available<br />
measurement attribute, <strong>and</strong> they are viewed in many cases as the most relevant<br />
attribute.)<br />
• Reliable: verifiable, neutral <strong>and</strong> representationally faithful. The accounting definition<br />
of faithfulness is when neutral, representational, independent measurements would<br />
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agree. (Fair values are viewed by some parties as inherently less reliable than other<br />
measurements.)<br />
• Comparable: similar events <strong>and</strong> transactions are accounted for in the same way.<br />
Comparability is very important to FASB <strong>and</strong> the Board creates both st<strong>and</strong>ards <strong>and</strong><br />
implementation guidance to enhance comparability.<br />
The speaker explained that FASB's current thinking about fair value measures has two main<br />
thrusts. Firstly, wherever possible, funds should use observed prices for identical items, or for<br />
similar items (adjusted for dissimilarities). Some caveats: Prices are not considered reliable if<br />
the exchange is between related parties, or if the exchange includes other elements, or if there<br />
is a legal/regulatory compulsion, or if one party to the exchange is in financial difficulties.<br />
Furthermore, as the observed price becomes more distant in time, it becomes less useful as a<br />
fair value measure. Finally, transaction costs should be excluded <strong>and</strong> the midpoint of the bidasked<br />
spread should be used. Secondly, in the absence of observable prices, the FASB speaker<br />
noted that valuators should use models <strong>and</strong> assumptions that market participants would use<br />
(an example of a "model assumption" is a multiple of net earnings or EBITDA).<br />
The speaker moved on to discuss certain valuation practices (largely those covered in the<br />
BVCA proposal) in light of current FASB policy. The practices/proposals covered in this<br />
discussion included:<br />
• The deliberate use of conservatism;<br />
• The practice of using different measures for different kinds of business models (e.g.<br />
venture vs. buyout);<br />
• The use of block discounts;<br />
• The practice of discounting restricted securities;<br />
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• The use of numerical rules.<br />
Regarding the deliberate use of conservatism, the speaker first defined what "conservatism"<br />
means in an accounting context: the “deliberate <strong>and</strong> consistent understatement of assets or<br />
income or both.” Because FASB calls for unbiased measurements, it rejects deliberately<br />
conservative valuation practices. Regarding the practice of using different measures for<br />
different kinds of business models (as the ILPA documents suggest for VC <strong>and</strong> buyout funds),<br />
the speaker noted that some reporting st<strong>and</strong>ards (e.g. FAS 115) are already based on intent or<br />
on an entity-specific business model, but -- that said -- FASB's experience with intent-based<br />
st<strong>and</strong>ards is decidedly mixed. There can be difficulties properly describing what the intent<br />
<strong>and</strong>/or business model is; in short, such st<strong>and</strong>ards are problematic to apply. FASB is still<br />
wrestling with the issue of block discounts. At the moment, the Board wants to disallow block<br />
discounts because of the inability to define the circumstances for which discounts would be<br />
required, as well as for difficulties in describing how to measure/record the discount.<br />
Regarding discounts for restricted securities (per FAS 115), FASB's tentative position closely<br />
follows the SEC's existing regulations: Adjust prices of otherwise similar assets for the effects<br />
of the restriction. The speaker added that intent is not an issue in such cases because the<br />
restrictions are contractual or legal. Finally, the speaker moved on to FASB's thinking about<br />
the use of numerical rules (as in BVCA proposals for block discounts). The speaker noted<br />
that, while some reporting st<strong>and</strong>ards contain numerical rules (e.g. FAS 13 <strong>and</strong> FAS 123),<br />
some accountants believe that numerical rules encourage transaction structuring. On the other<br />
side of this very heated debate are those accountants who think such rules are necessary to<br />
reduce implementation difficulties.<br />
The final part of the speaker's presentation focused on FASB's fair value measurement<br />
project. The goal of the project is to develop a single st<strong>and</strong>ard for measuring fair values, to be<br />
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applied whenever the relevant reporting rules require a fair value measurement. Such a<br />
st<strong>and</strong>ard would apply broadly, to both nonfinancial <strong>and</strong> financial assets/liabilities, <strong>and</strong><br />
decisions about measurement attributes would continue to be made one at a time. The<br />
development of this (unprecedented, in FASB history) st<strong>and</strong>ard will include some of the<br />
discussion that is currently in Concept Statement 7 (essentially a discounting approach to fair<br />
value) -- <strong>and</strong> thus the project aims to update <strong>and</strong> exp<strong>and</strong> those Concept Statements that pertain<br />
to measurement.<br />
Q&A Session<br />
The first question came from the PEIGG speaker. He noted that the private equity industry<br />
has always had a conservative approach to valuations, <strong>and</strong> asked why the FASB "can't accept"<br />
that approach. The FASB speaker responded that the Board's mission is to provide neutral<br />
information, <strong>and</strong> that purposely biased reporting is not consistent with that mission.<br />
The next questioner asked about the reliability of fair value measures, <strong>and</strong> asked what the<br />
FASB thinks is an acceptable level of reliability in financial reports. The FASB speaker<br />
noted the pervasiveness of estimates in financial reports <strong>and</strong> acknowledged the FASB’s<br />
concern about the reliability of fair value measures. When asked whether estimates should be<br />
recorded with an uncertainty measure, the FASB speaker responded that that idea has not<br />
been considered, but also noted that fair value estimates do reflect uncertainty to some extent,<br />
because the measurement is based on probability-weighted assessments of possible outcomes.<br />
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Speaker #2<br />
The speaker began by saying that private equity valuation guidelines aren't likely to come<br />
from industry organizations because U.S. firms can't be forced to join an industry group. He<br />
also noted that the top 25% of firms are those that "don't want to play by anyone's rules,"<br />
creating a conundrum for the rest of firms. He feels that the industry as a whole needs to find<br />
stability, reliability, order <strong>and</strong> structure in capital markets.<br />
In late 2001, his accounting firm conducted a voluntary survey to assess how venture capital<br />
firms value their portfolios. One of the key conclusions he drew from the survey results was<br />
that the so called “NVCA guidelines” are largely misunderstood. Many firms think that they<br />
are following NVCA guidelines, when in reality no one agrees on what those guidelines mean<br />
in practice. The speaker opined that the NVCA guidelines were a good place to start, but they<br />
should not be the end of the story.<br />
The speaker then reviewed some of the questions asked <strong>and</strong> answered on the survey. One<br />
question asked whether guidelines might be a good tool to extract the truth from inherently<br />
dishonest GPs. Most respondents rejected this idea, saying that the structure of the VC market<br />
eliminates the dishonest GPs very efficiently (LPs won’t reinvest in a partnership with<br />
someone they can’t or won’t trust.) Another question asked whether valuing the private sector<br />
is just too difficult, <strong>and</strong> can’t or shouldn’t be done?<br />
Another set of questions dealt with under what circumstances GPs should write up <strong>and</strong> write<br />
down investments. In general, respondents felt that write-ups should be transaction-based,<br />
<strong>and</strong>, specifically, they felt that strategic investors have different incentives than other<br />
investors <strong>and</strong> GPs shouldn’t mark up a round when it’s just them investing. As for writedowns,<br />
the survey found that firms are more likely to write down than write up investments.<br />
Many respondents indicated that Q2 is a popular time for firms to write down investments.<br />
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The speaker pointed out an answer to one survey question that may be of some concern.<br />
When the question was posed whether respondents would write down a company that had a<br />
new round of funding, but wasn't meeting milestones <strong>and</strong> seemed to be in trouble, 40% of<br />
firms said that they wouldn’t write down that investment. The speaker suggested that this is<br />
because VCs are inherently optimistic; no one wants to write down an investment, because it<br />
seems to be a self-fulfilling prophecy. Once you write down something to zero, it tends to fall<br />
off of a firm's radar screen. What's more, VC financial statements tend to get around; so<br />
writing a company valuation down may doom it in the eyes of other industry players.<br />
Here, he raised the point that good business decisions at VC firms are not always good<br />
accounting decisions. Thus, not writing down in above situation can be understood as a valid<br />
business decision, but not a responsible accounting decision. What's more, the above scenario<br />
demonstrates how the FOIA creates huge issues for the industry. Because of FOIA, there have<br />
been cases of LPs receiving information from GPs about portfolio companies <strong>and</strong> then giving<br />
that information back, so the documents won't be in their files, which are public domain.<br />
In response to questions about discounting practices, survey respondents said they took<br />
anywhere from a ten to a 50% discount, <strong>and</strong> then respondents characterized the discount as<br />
being the “industry st<strong>and</strong>ard.” The speaker remarked that it is not surprising that discounting<br />
practices disorient LPs! The question, "After lockup, do you take block discounts?" yielded<br />
an overwhelming diverse set of responses, indicating that firms' policies are all over the map<br />
on this issue.<br />
One survey question asked how much VC firms talk to each other (about valuation issues<br />
regarding the same portfolio companies). Less than half of the firms said that they actually<br />
talk to other firms that are co-investors in a company. Some CFOs say that’s because they<br />
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think it is illegal (i.e. in violation of anti-trust laws). The speaker joked that it is time to get<br />
the word out: Discussions among VC firms are not illegal!<br />
Finally, the speaker revealed that two-thirds of surveyed GPs characterized their practices as<br />
"industry consistent," noting that there seems to be an industry perception that there are de<br />
facto st<strong>and</strong>ards that are being followed.<br />
Q&A<br />
The first question asked whether valuations could be influenced by liquidation preferences.<br />
The speaker responded that, yes, firms could do this if they can represent that the preferences<br />
will be followed (he remarked that such preferences often are not followed in practice).<br />
The next question inquired about the state of accounting in portfolio companies, asking<br />
whether the data received from those companies are reliable. The speaker responded that<br />
since most VC’s have very professional staffs, he typically doesn't even ask for the financial<br />
statements of portfolio companies. In the case of buyout firms, the speaker indicated he didn't<br />
know but thought the process should be very different than with VCs since buyout target<br />
companies typically have more "substance" than portfolio companies at a VC. Thus buyout<br />
firms often have one of the major national accounting firms audit the companies in their<br />
portfolio.<br />
At this point, a debate began about whether VC firms talk among themselves about the<br />
portfolio companies they have in common, <strong>and</strong> whether such conversations are a good thing<br />
or a bad thing. One managing partner at a VC fund suggested that, if the survey were taken<br />
today, more firms would say they were talking with each other. He indicated that some firms<br />
do talk amongst themselves to get a better feeling on how other VCs feel about particular<br />
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portfolio companies, <strong>and</strong> to forecast ideas for future rounds. Another participant identified<br />
the potential problem with such conversations -- syndicate risk -- <strong>and</strong> others chimed in that<br />
anti-trust concerns (i.e. collaborating on valuations) should be taken seriously. One GP at a<br />
French venture capital firm wondered if, by discussing portfolio companies amongst<br />
themselves, VCs might effectively be giving those private companies "market values." She<br />
added that too much collaboration among VCs might harm the prospects of early-stage<br />
companies.<br />
Speaker #3<br />
The speaker introduced himself by saying he was an auditor in a former life, <strong>and</strong> is still “in<br />
recovery.” He now spends most of his time working with LPs <strong>and</strong> has observed that<br />
frustration among certain LPs is focused on inconsistency in the application of GAAP. For<br />
example, it is common to receive multiple different portfolio valuations of the same company.<br />
This forces LPs to ask a lot of questions. He feels that, while there will always be some<br />
variability between different firms' valuation of the same portfolio companies, it shouldn’t be<br />
a wide gap.<br />
He identified two broad categories of LPs: those for whom P&L matters, <strong>and</strong> those for whom<br />
the only thing that matters is how much cash is in the investment (do I get back in year 10<br />
what’s in my capital account?). The former needs to feel like they are getting reliable,<br />
relevant, industry-comparable data. The speaker opined that most of those LPs don’t think<br />
they're getting that. Why? Because there are many different policies for write-downs <strong>and</strong><br />
write-ups: namely, cost, performance <strong>and</strong> overall market in the sector, all three of which have<br />
GAAP obligations <strong>and</strong> all of which are clearly audited.<br />
He emphasized that LPs don’t want "one number" from VCs, but are looking for more<br />
consistency <strong>and</strong> reliability within a tighter range. At this point, the FASB speaker interjected<br />
that a precision-weighted average is much better than any one estimate, as long as the VCs all<br />
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have same measurement objective (she drew an analogy to the forecasting of earnings<br />
estimates by sell-side analysts). Another participant weighed in that LPs are simply going to<br />
have to start learning more about financial statements, particularly the notes -- LPs really have<br />
to read those notes. Here, the FASB speaker noted that there is an "impassioned minority" of<br />
accountants who want to get rid of the earnings per share number altogether (they feel that<br />
measure can be easily abused), <strong>and</strong> simply use financial statements with line item details.<br />
Another debate opened up when the question was raised: How do you reconcile accounting<br />
statements versus payout arrangements? Make sure that you create explicit payout<br />
arrangements? Someone else made the point that some GPs write up more easily/quickly,<br />
while some write down more easily/quickly, thus complicating the picture. Speaker #2<br />
advocated what he called a "free-market" approach to payouts/partnership arrangements,<br />
saying "If you let GPs <strong>and</strong> LPs talk, they will work it out. Most GPs want their current fund<br />
not to be their last one, so they are motivated to work out a solution, return management fees,<br />
etc, in order to maintain LP goodwill. Another participant responded to this comment with<br />
disbelief, arguing that such compromises must be negotiated into partnership agreements<br />
beforeh<strong>and</strong>. A GP at a VC fund agreed with Speaker #2's sense that LPs <strong>and</strong> GPs could work<br />
out their differences less formally, saying that "a good LP/GP relationship is one where the<br />
LP doesn't even have to ask the question -- GPs should, under appropriate circumstances, just<br />
waive fees to earn the goodwill of their LPs." Arguing that an overemphasis on partnership<br />
agreements can backfire, Speaker #2 asked the group, "Do you want to invest in the fund with<br />
the best terms or in the fund with the best managers?"<br />
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Moderator:<br />
Session 3 : Implementation – The Hard Reality<br />
Professor Michael Horvath, Center for <strong>Private</strong> <strong>Equity</strong> <strong>and</strong> Entrepreneurship<br />
Official Speakers:<br />
1. Representative from the GP community<br />
2. Representative from a law firm<br />
3. Representative from the Fund-of-Funds community<br />
4. Representative from a major national accounting firm<br />
Speaker #1<br />
The first panelist, a managing director at a private equity firm, began by focusing on the<br />
reporting side of the debate. He felt that one of the issues that had not yet been addressed was<br />
the communication level between General Partners <strong>and</strong> their Limited Partners <strong>and</strong> making<br />
sure the GPs were spending enough time <strong>and</strong> effort communicating with their investors. He<br />
suggested a set of best practices based his firm’s reporting procedures. His firm distributes<br />
eight reports a year to its LPs (two each quarter), holds two LP meetings per year, <strong>and</strong> tries to<br />
meet one-on-one with each of its LPs at least once a year. With respect to the two quarterly<br />
reports, the first is issued about 10 days after the close of the quarter <strong>and</strong> consists solely of the<br />
financial statements. The panelist made a side comment that he would prefer not to release<br />
information solely in that format, because the financials alone, without any substantive<br />
narrative <strong>and</strong> backup figures, are not particularly valuable. This additional information is sent<br />
to the LPs 30 days later in the form of an activity report, which details the company’s<br />
operating performance <strong>and</strong> profit, cash position, backlog, pipeline, <strong>and</strong> other statistics to help<br />
the investor underst<strong>and</strong> the overall health of the company. This gives the investor, who<br />
generally looks briefly through a report to find the valuation of the each investment <strong>and</strong><br />
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moves on, an idea of the momentum of each portfolio company <strong>and</strong>, in turn, the portfolio as a<br />
whole.<br />
The panelist suggested that this is the type of information that LPs need to assess both the<br />
short-term results <strong>and</strong> the long-term potential of the fund. Issues can <strong>and</strong> do arise, however,<br />
with the disclosure of information, in terms of misinterpretation of data <strong>and</strong> loss of<br />
confidentiality. The latter can arise from state Freedom of Information Act (FOIA) issues that<br />
require access to public documents, which would include the above described activity reports<br />
if they are held by state agencies (i.e. pension funds). Obviously, most of the information<br />
described in the firm’s activity reports is not meant for public eyes, <strong>and</strong> a portfolio company’s<br />
competitive position would be severely compromised in the event that other industry players<br />
or investors gained access to this information. In some cases where the LPs are subject to<br />
FOIA issues, the firm has had to separate these LPs out <strong>and</strong> meet with them one-on-one to<br />
discuss the fund’s performance <strong>and</strong> then take the activity report back at the end of the<br />
discussion. Clearly this is a sub optimal solution, <strong>and</strong> it becomes difficult for each side to<br />
implement when looking at larger funds, which have large numbers of LPs, <strong>and</strong> large LPs<br />
who have hundreds of fund investments.<br />
On the valuation side, the panelist briefly discussed his firm’s policies, including the concept<br />
of discounting publicly traded securities. In this respect, the firm discounts from the last trade<br />
(bid price) securities that are not freely tradable (i.e. under lockup or high ownership relative<br />
to the float or trading volume). The firm also uses a “six month rule” to discount valuations<br />
of companies that will be in need of cash during this time period. This becomes tricky,<br />
however, as it is difficult to determine a “market price” for a future follow-on round of<br />
financing, <strong>and</strong> the firm needs to be careful not to create a situation where there is a self<br />
fulfilling prophecy, whereby the price of the new round is effectively set as a result of the<br />
discount given to the valuation based on the need for the financing. The firm’s valuations are<br />
reviewed by its Advisory Committee, <strong>and</strong> representatives from major audit firms are also<br />
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invited <strong>and</strong> are encouraged to speak up. Again, the panelist stressed that in the absence of the<br />
more detailed activity reports, which give an idea of the overall momentum of the portfolio,<br />
the quarterly valuations can be misleading, <strong>and</strong> they should be viewed in conjunction with <strong>and</strong><br />
somehow linked to the financial statements of the investee company. Also with respect to<br />
valuation, the firm runs a Monte Carlo simulation on its portfolio twice a year to get a<br />
perspective on the potential performance <strong>and</strong> attempt to use more quantitative, statistical<br />
analysis <strong>and</strong> minimize the amount of subjectivity involved in the valuation process.<br />
Speaker #2<br />
The second panelist, a partner at leading law firm, addressed three issues: 1) valuation as it<br />
relates to compensation (carried interest <strong>and</strong> clawbacks), 2) public disclosure with respect to<br />
open record laws <strong>and</strong> LPs, <strong>and</strong>, 3) his general opinion on valuation guidelines. The<br />
compensation effects of valuation were raised earlier, when a representative of a large LP<br />
investor in private equity complained that inaccurate valuations were affecting carried interest<br />
<strong>and</strong> management fee calculations in cases where high valuations resulted in large carry<br />
payments <strong>and</strong> management fees <strong>and</strong> then the investments were written off. Adding to the<br />
frustration was the fact that clawback provisions were not forceful enough <strong>and</strong> LPs generally<br />
felt like they had to beat many GPs over the head to recover money that had been paid out.<br />
The panelist outlined the various different types of waterfall arrangements that are included in<br />
LP agreements <strong>and</strong> how they deal with two issues, namely the clawback <strong>and</strong> the time value of<br />
money:<br />
1. No carried interest payments until all committed capital has been returned to the LPs –<br />
this eliminates issues with both the clawback <strong>and</strong> the time value of money.<br />
2. No carried interest payments until all contributed capital has been returned to the LPs<br />
– this ameliorates (but does not completely eliminate) the issues with the clawback,<br />
<strong>and</strong> it eliminates time value of money issues.<br />
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3. The third method, which involves a calculation <strong>and</strong> distribution of carried interest<br />
prior to all capital being returned is the most prevalent in the US (more so than in<br />
Europe), <strong>and</strong> is what is causing the most heartburn with LPs today. This is<br />
particularly relevant in examples like 1999 vintage year venture funds, where the GP<br />
has received large carried interest payments based on early success, but now the fund<br />
is in danger of being underwater for good. The distribution provisions incorporate<br />
NAV in some way to determine payouts (usually with a specific test or through the<br />
return of cost plus write-offs). Some LP agreements try to govern payouts a bit more;<br />
however, even an IRR hurdle test is subject to valuation issues. Similarly,<br />
management fees are affected by valuations in the later years of a fund’s life. While<br />
fees are generally calculated based on a percentage of committed capital on the front<br />
end, when the fund starts its winding down period fees are generally calculated as a<br />
percentage of the cost of the remaining investments (less writedowns). Clearly the<br />
valuations used <strong>and</strong> timing of writedowns can have a large impact on the amount of<br />
fees paid by the LPs, <strong>and</strong> the agreements often have provisions for valuation st<strong>and</strong>ards<br />
(GAAP <strong>and</strong> other) based on the lower of cost or market baked into them as a result.<br />
Public disclosure of fund information has become an issue as a result of increased pressure on<br />
some LP’s (most famously CalPERS <strong>and</strong> UTIMCO) from recent lawsuits (by the San Jose<br />
Mercury News <strong>and</strong> the Houston Chronicle) to reveal investment information in the LPs’<br />
records, namely portfolio company information of private equity fund investments. Federal<br />
FOIA <strong>and</strong> state open record laws were the basis for the lawsuits. While these two high-profile<br />
lawsuits were most likely driven by the newspapers’ desire to get a story, other organizations<br />
have a vested interest in gaining access to this information. These parties include portfolio<br />
company competitors for obvious reasons, unions trying to find out portfolio company labor<br />
policies in an effort to influence labor-friendly policies, organizations trying to compile <strong>and</strong><br />
sell the information, <strong>and</strong> portfolio company management trying to derive the PE firms’<br />
opinions of the company or the value of options based on valuation data.<br />
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CalPERS has settled <strong>and</strong> agreed to publish only the most basic information, namely the<br />
individual fund IRR <strong>and</strong> cash in/cash out data on a quarterly basis. Despite this, SJMN is still<br />
suing <strong>and</strong> there are similar issues being resolved in Illinois, Washington (Mark O’Hare), <strong>and</strong><br />
Massachusetts (Mass PRIM vs. the Attorney General). The result has actually been<br />
counterproductive – since it is unclear where the information is ending up <strong>and</strong> what it is being<br />
used for, many GPs are starting to curtail their reporting rather than increase it. Some GPs are<br />
even resorting to reporting aggregate portfolio or industry-based valuation numbers rather<br />
than disclosing individual company valuations. This is in direct conflict with the LPs’ desires<br />
for more disclosure (many of the representatives at the conference were less worried about<br />
what the actual valuations than they were about receiving detailed information about how the<br />
valuations were derived).<br />
With respect to guidelines, the panelist suggested that the LP agreements include written<br />
valuation guidelines. Guidelines should be approved, at the very least, by a subset of the<br />
limited partners which comprise the advisory committee of the limited partnership. He noted<br />
that the guidelines should be a living document that evolves over time, <strong>and</strong> it must not be a<br />
cumbersome exercise to modify them.<br />
Speaker # 3<br />
The third panelist was the head of a fund-of-funds group <strong>and</strong> offered the interesting<br />
perspective of being both on the GP <strong>and</strong> the LP side of the business. He began his remarks by<br />
offering a look at the PE world as it is today <strong>and</strong> stressing the need to underst<strong>and</strong> where it is<br />
going. The existence of the valuation debate <strong>and</strong> the need for conferences like this one is the<br />
result of the bursting of the bubble. He made the comment that we probably wouldn’t be<br />
talking about this if returns had continued to go up.<br />
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That said, the institutionalization of private equity is the inevitable result of the growth a<br />
maturation of the asset class as more capital <strong>and</strong> players have entered the industry. As a<br />
result, there is more of a focus on regulation, oversight, <strong>and</strong> governance. LPs need quick,<br />
accurate information on which to base their investment decisions, particularly when it comes<br />
time to rebalance their portfolios, <strong>and</strong> they want more quantitative assessments of valuation<br />
<strong>and</strong> portfolio company performance. Unfortunately there appears to be a countertrend, with<br />
many GPs wanting to restrict information flow into the market. The panelist believed that<br />
most still strong sentiment in the GP community that cash is king, <strong>and</strong> that interim valuations<br />
don’t really matter.<br />
This will be a problem, however, when GPs try to come back to market for new funds in<br />
2004-2005 (many GPs are working through their overhangs <strong>and</strong> the panelist expected a flood<br />
of fundraising in the market in the coming years). When they do come back to market, GPs<br />
are going to face skeptical LPs who are likely to be less inclined to base investment decisions<br />
on unrealized gains. It is in the GP’s best interest to present accurate, defensible interim<br />
valuations in order to give its investors an idea of the direction of the portfolio, even though<br />
they are locked in for the long term. When the market was hot, funds attracted a lot of<br />
investors who did not really underst<strong>and</strong> the asset class. With investment periods increasing<br />
due to the lack of exit opportunities relative to a few years ago, it’s harder to simply hold<br />
things at cost given the glut of unpleasant surprises recently. If the GPs want to raise<br />
additional funds in the coming years, they need to communicate better with investors to<br />
educate them <strong>and</strong> allow them to underst<strong>and</strong> where the portfolio is going. Many CIO’s are<br />
now trying to shorten their J-curves <strong>and</strong> educate their LPs in order to be able to raise funds in<br />
the coming years.<br />
While the panelist agreed that increasing the accuracy <strong>and</strong> transparency of information in<br />
interim reporting would be helpful if used correctly, he pointed out that there needs to be<br />
more work done on how this can be accomplished. An interesting analogy to the real estate<br />
Page 43 of 59
market was brought up. The panelist pointed out that, right or wrong, the real estate industry<br />
has been forced to use periodic appraisals to value investments. The two asset classes are<br />
similar in that both are long-term, privately held investments. Real estate is appraised<br />
periodically, regardless of the intention (or lack thereof) of the investor to sell in the near<br />
term. Some argued that a real estate appraisal in a depressed market didn’t mean much if the<br />
holder had no intention to sell until the market rebounded. Periodic appraisals, in their minds,<br />
would result in unwarranted <strong>and</strong> misleading volatility in valuations <strong>and</strong> serve to confuse<br />
investors. However the appraisal process did become st<strong>and</strong>ard in the real estate industry (<strong>and</strong><br />
volatility ensued), <strong>and</strong> the panelist cautioned that GPs should underst<strong>and</strong> that the PE industry<br />
could be moving in the same direction.<br />
There appears to be a thrust by some LPs to make the valuation process as simple as possible<br />
given their limited resources; however, the panelist believed that pushing the work on the GPs<br />
to make life easier for LPs who can’t do it themselves is short sighted <strong>and</strong> would be costly<br />
(both in terms of dollars <strong>and</strong> the opportunity cost of investment professionals’ time). In his<br />
opinion the LPs need to take responsibility to increase their underst<strong>and</strong>ing of the asset class in<br />
conjunction with GP efforts to improve reporting <strong>and</strong> valuation. While GPs need to be more<br />
transparent about their valuation <strong>and</strong> methodologies, LPs need to be able to underst<strong>and</strong> the<br />
limitations of these methodologies <strong>and</strong> do the work themselves in researching <strong>and</strong> assessing<br />
those valuations.<br />
Speaker #4<br />
The fourth <strong>and</strong> final panelist, a valuation specialist for a major investment banking firm,<br />
expounded on the previously raised idea of the relationship between GPs <strong>and</strong> LPs in the<br />
valuation process. More attention is being given to fair value, <strong>and</strong> in order to synthesize this<br />
fair value concept, there is an increasing need for st<strong>and</strong>ards <strong>and</strong> guidelines, <strong>and</strong> there will be<br />
more of an emphasis on regulation. Clearly these guidelines will not get everyone to the exact<br />
same number, <strong>and</strong> there will be a fair amount of variation in reported valuations as a result.<br />
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LPs need to underst<strong>and</strong> that this will happen, <strong>and</strong> GPs need to be forthright in disclosing in<br />
detail their methodologies so that investors can underst<strong>and</strong> how every one got the different<br />
numbers <strong>and</strong> make their own decision with regard to the fair value of the asset. The panelist<br />
admitted that there would be increased volatility <strong>and</strong> likely increased tension as a result of any<br />
attempts to implement a mark-to-market system to determine fair value, but that can be<br />
remedied by educating the investor base <strong>and</strong> improving GP-LP communication. Once the<br />
dialogue is started <strong>and</strong> trust is built between the GPs <strong>and</strong> LPs, the panelist opined, the<br />
valuation issue would fall away.<br />
Q&A Session<br />
The discussion quickly turned back to the issue of compensation, in particular with respect to<br />
clawbacks <strong>and</strong> management fees. While valuation clearly does have impact on clawback<br />
issues, the lack of valuation st<strong>and</strong>ards did not necessarily cause the clawback issues that many<br />
LPs are now facing. The root cause was the bubble <strong>and</strong> the resulted inversion of the J-curve.<br />
Even using lower of cost or market some GPs had enormous unrealized appreciation in their<br />
funds <strong>and</strong> took hefty carried interest payments, but now some of the investors are concerned<br />
about getting out whole by the end of the fund. Enforcing clawbacks has become a<br />
troublesome endeavor for many LPs.<br />
One panelist, a GP himself, suggested that the LP should be viewed as a customer, <strong>and</strong> if the<br />
investors are genuinely concerned about compensation, the GPs should address this. He<br />
contended the partnership responsibilities went beyond the LP agreement <strong>and</strong> that GPs should<br />
be doing everything they can to maintain the relationship, including amending clawback<br />
provisions to reflect the current environment. Clearly the market has changed, <strong>and</strong> LP<br />
agreements (which were written when investors were dying to get into these funds <strong>and</strong><br />
accepting egregious terms to do so) have not changed accordingly. With the market where it<br />
is in terms of low valuations for new investments, GPs should be focusing on their<br />
investments <strong>and</strong> relying on consistent performance, the training <strong>and</strong> grooming the next<br />
Page 45 of 59
generation of investing professionals, <strong>and</strong> long-term capital gains for compensation rather<br />
than focusing on management fees <strong>and</strong> early distributions of carried interest for incentives.<br />
A few counterpoints came out of the discussion. First: Amending LP agreements <strong>and</strong> trying<br />
to entice investors based on terms will result in the further bifurcation of the GP community<br />
between the “haves <strong>and</strong> the have-nots” -- here, the example of the recent Sequoia controversy<br />
was cited. This also led to a discussion once again about the GP/LP relationship, <strong>and</strong> the fact<br />
that with larger <strong>and</strong> larger funds out there, the relationship has changed from a partnership to<br />
a business transaction. One-on-one meetings with LPs works fine for smaller funds with<br />
fewer investors, but mega-funds with enormous investor bases simply cannot do this.<br />
Similarly, LPs with multiple fund investments <strong>and</strong> hundreds of underlying portfolio<br />
investments don’t have the capacity either. One panelist did point out however, that the press<br />
usually highlights the negative stories <strong>and</strong> ignores the funds that have rebated fees, forgiven<br />
commitments <strong>and</strong> escrowed carried interest payments in response to LP desires. He also<br />
pointed out that while work still needs to be done, the GP community (albeit in its own self<br />
interest in light of the upcoming need for fundraising) recognizes the importance of LPs <strong>and</strong> is<br />
focusing on more than ever, as evidenced by large investments in back office staffing <strong>and</strong><br />
technology.<br />
Another subject that arose was the importance <strong>and</strong> value of quarterly reporting. LPs want<br />
more frequent, efficient reporting that goes beyond simple return <strong>and</strong> valuation number in<br />
order to both assess the movement of their portfolios <strong>and</strong> rebalance to make the proper asset<br />
allocations as dictated by their fiduciary duties. Some also see fair value accounting <strong>and</strong> the<br />
opportunity to write-up investments as a mechanism to bolster confidence in the market. The<br />
meat of the argument against “over-reporting” from the GP perspective came on the basis of<br />
avoiding the additional cost <strong>and</strong> distraction of reporting, avoiding the focus on short-term<br />
results, <strong>and</strong> whether fair value loses value as a measurement tool if quarterly reporting results<br />
in information overload. FOIA reared its head again when someone pointed out that the<br />
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quality of information was going down because some GPs didn’t want it ending up in the<br />
h<strong>and</strong>s of the press. This was lesser point, however.<br />
The question of compensation resurfaced when an attendee pointed out that they were paying<br />
huge dollars in management fees but were not able to get the information they wanted.<br />
However, the body of the discussion was focused on what needs to be done with respect to<br />
determining the information to be reported <strong>and</strong> how best to present it. Many LP<br />
representatives cited the wide disparity in the detail <strong>and</strong> quality of reporting among different<br />
funds <strong>and</strong> stressed the need for consistency. Some GP representatives countered by noting<br />
that there was an equally wide disparity among LPs with regard to the type of information<br />
each investor wanted. Some want great detail, while others just want nothing more than a<br />
number. One GP suggested that the LPs get together <strong>and</strong> take a bottom-up approach to<br />
forming a boilerplate for reporting that lays out what they can agree upon to be an appropriate<br />
level of information <strong>and</strong> the appropriate method for presenting it consistently. This idea was<br />
not entirely embraced by the LP representatives.<br />
In wrapping up the session, it was suggested that GPs <strong>and</strong> LPs get together <strong>and</strong> figure out a<br />
mutually agreeable solution. The opinion of most in the room was that the actual physical<br />
reporting issues should be an easy fix with the implementation of a st<strong>and</strong>ard reporting<br />
template that incorporated input from all constituents. While public record laws could have<br />
an impact on this, the two groups should at least try to tackle the content <strong>and</strong> structure of the<br />
reporting package before addressing FOIA issues. On the valuation side, most in the room<br />
agreed that subjectivity in GP valuations was not an entirely bad thing, <strong>and</strong> most investors are<br />
not looking for everyone to have the exact same number, but they do want a clear <strong>and</strong> detailed<br />
explanation of how each number was derived. Furthermore, they felt that if everyone uses the<br />
same valuation st<strong>and</strong>ards, even with GP subjectivity involved, the dispersion of the results<br />
would be minimized, <strong>and</strong> it would considerably easier for everyone to determine what really<br />
is a fair value for PE investments.<br />
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Session 4: Breakout Discussions<br />
Session Leaders:<br />
Professor Colin Blaydon, Center for <strong>Private</strong> <strong>Equity</strong> <strong>and</strong> Entrepreneurship<br />
Professor Michael Horvath, Center for <strong>Private</strong> <strong>Equity</strong> <strong>and</strong> Entrepreneurship<br />
Professor Fred Wainwright, Center for <strong>Private</strong> <strong>Equity</strong> <strong>and</strong> Entrepreneurship<br />
Professor Rick Antle, Yale School of Management<br />
In this session, conference participants split into four groups <strong>and</strong> went into separate<br />
conference rooms. Each group wrestled with assigned discussion questions <strong>and</strong>, when<br />
everyone reunited, a representative from each presented the conclusions.<br />
Who really benefits from the existence of guidelines?<br />
The group concluded that trying to decide whether LPs or GPs benefit more is moot. Rather,<br />
the real upside of having reliable guidelines is that, by removing the crisis of confidence<br />
investors (especially new entrants) have about private equity, such guidelines will strengthen<br />
the industry <strong>and</strong> drive capital formation. In short, good guidelines will make the pie bigger for<br />
everyone. The caveat here is that "we have to get it right" -- inconsistent or contradictory<br />
guidelines will simply make things worse.<br />
Realistically, can multiple funds ever reach exactly or even approximately the same<br />
valuations for the same portfolio companies?<br />
Group members voiced the opinion that LPs don't care all that much about getting different<br />
numbers about the same portfolio companies as long 1) the assumptions/logic behind each set<br />
of numbers is clear to them, <strong>and</strong>, 2) the discrepancy between valuations of the same assets<br />
isn't profound.<br />
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A related debate arose in this group's discussion regarding the practice of "mark-to-market"<br />
(vs. cost-driven) valuations. Some group members observed that marking-to-market will<br />
increase volatility <strong>and</strong> wondered whether the industry "is ready for that" volatility (especially<br />
since PE traditionally draws a lot of investors precisely because it is considered less volatile<br />
than public markets). But other voices in the group pointed out that "at cost" merely<br />
disguises/muffles the volatility that is there all along, so PE investors shouldn't necessarily<br />
shy away from marking-to-market.<br />
Is personal compensation (of both GPs <strong>and</strong> LPs) driven by valuations?<br />
The group's answer here was an unequivocal "yes."<br />
Does" conservatism" mean always picking the low number in a range or is it about<br />
conservatively applying underlying principles (e.g. fair market value)? Is conservatism<br />
another name for earnings management?<br />
The group defined "conservatism" as the use of cost-based valuation methods (rather than the<br />
conservative application of fair value-based methods). Regarding the debate between a "no<br />
surprises" cost-based approach <strong>and</strong> a more volatile, fair value-driven approach, the group<br />
endorsed the latter.<br />
Can consensus be reached for defining "fair value"? Should there be fair value definitions<br />
by sub-sector within private equity?<br />
The group concluded that GAAP (<strong>and</strong> its definition of fair value) is the accepted st<strong>and</strong>ard, <strong>and</strong><br />
it should be applied to private equity.<br />
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Who are the users of this information on valuation?<br />
The group listed the constituents it felt were the chief users of valuation information: LPs who<br />
want to rebalance their investments; shareholders in public companies that have invested in<br />
private equities; interim management <strong>and</strong> public officials.<br />
In a related point, the FASB speaker suggested that both LPs <strong>and</strong> portfolio companies have<br />
clear incentive to deal with each other directly (a prospect that would be made substantially<br />
easier by highly st<strong>and</strong>ardized valuation rules). As the information broker/intermediary, VCs<br />
represent cost to both LPs <strong>and</strong> portfolio companies. Several audience members responded by<br />
remarking that VCs bring specialized investing <strong>and</strong> company building skills that are necessary<br />
for these investments.<br />
Are there third-party rulemaking actions outside of the industry that might impact or<br />
prevent industry-driven guidelines?<br />
The group answered this question with a question of its own: Why should a rule-making body<br />
need to implement good, transparent valuation practices when those practices can easily be<br />
assured in partnership agreements?<br />
If guidelines should be developed, which entity should be responsible for managing the<br />
process?<br />
The group felt that either PEIGG or a joint venture of ILPA <strong>and</strong> the major national accounting<br />
firms should be responsible for developing guidelines. Additional representation from AIMR<br />
could be added to PEIGG. Additional potential combinations of industry groups were also<br />
discussed. A st<strong>and</strong>ards setting body might be needed to rule on interpretations <strong>and</strong> changes.<br />
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Who should bear the costs of applying guidelines?<br />
The group concluded that ultimately LPs will bear the costs, including increased audit fees<br />
charged to funds <strong>and</strong> increases in GP staffing.<br />
What should be the next steps after this conference?<br />
Publish a summary of the conference proceedings <strong>and</strong> then organize a consortium meeting of<br />
EVCA, BVCA, ILPA, NVCA, AIMR <strong>and</strong> PEIGG.<br />
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A. BVCA <strong>Valuation</strong> Guidelines<br />
B. BVCA PowerPoint Presentation<br />
C. ILPA PowerPoint Presentation<br />
D. Keynote Presentation<br />
Exhibits<br />
For Exhibits A, B <strong>and</strong> C, go to this link:<br />
http://mba.tuck.dartmouth.edu/pecenter/research/pdfs/conference_proceedings_exhibits.pdf<br />
For Exbibit D, see next page.<br />
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Exhibit D: Keynote Speech<br />
A Scary Thought: Congress May Try to Fix<br />
<strong>Private</strong> <strong>Equity</strong> <strong>and</strong> Performance <strong>Reporting</strong><br />
Keynote Address by Tom Franco of Broadgate Advisors<br />
<strong>Private</strong> <strong>Equity</strong> <strong>Valuation</strong> <strong>and</strong> Performance <strong>Reporting</strong> <strong>Conference</strong><br />
June 2003<br />
Tuck School of Business at Dartmouth<br />
I was talking last week to David Carey, a senior editor of The Deal, about common valuation<br />
st<strong>and</strong>ards. David has been around a long time <strong>and</strong> is a very insightful guy. He told me that<br />
when KKR <strong>and</strong> Hicks Muse were in the market raising funds prior to the bankruptcy of Regal<br />
Cinemas, KKR was carrying its investment in the business at zero while Hicks Muse was<br />
carrying theirs at cost. I haven’t verified that independently, but it does put the issue of<br />
transparency <strong>and</strong> disclosure into focus. Who's right? And who now is asking?<br />
These are not new issues for private equity. They were there when I first started working with<br />
Clayton, Dubilier & Rice around the mid '80s. It became even more critical as pension <strong>and</strong><br />
endowment funds started to seriously invest in the asset class -- institutions who themselves<br />
had public reporting obligations to constituencies far beyond what sponsor organizations were<br />
used to dealing with - leading to some surprisingly convoluted linkages. An example of this<br />
were articles in the Houston Chronicle <strong>and</strong> Harpers in the mid - '90s that tried to disparage<br />
UTIMCO’s relationship with Hicks Muse, when Tom Hicks was on the board of regents of<br />
the University of Texas.<br />
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Today of course, issues of transparency <strong>and</strong> disclosure have been reignited by Enron,<br />
Worldcom, Healthsouth <strong>and</strong> the rest. In this sc<strong>and</strong>al -- charged environment, “private” must<br />
mean “secret” which must mean “hidden” which must mean “bad.” Just ask Freddie Mac <strong>and</strong><br />
Fannie Mae. Sounds like a prelude to the six most unsettling words that any business<br />
executive can ever hear from Capitol Hill: “Something needs to be done about…” You can<br />
fill in the blank with any number of choice catch phrases - many of which helped drive<br />
Sarbanes Oxley into law.<br />
The situation today in private equity resembles a difficult period for the industry when<br />
Congress wanted to ‘do something about’ the wave of debt-financed buyouts <strong>and</strong> takeovers<br />
that were turning corporate America on its head in the late '80s. There may be some relevant<br />
lessons for us today from that public positioning battle, which threatened the very existence of<br />
the industry. It is far from clear that the transparency <strong>and</strong> disclosure debate confronting<br />
private equity today represents a potential threat of the same magnitude. My theme,<br />
however, is that there could be political fallout that could prove to be more significant than<br />
the merits of the case presently being argued by industry participants.<br />
Legislation seemed almost inevitable in the wake of the legendary RJR Nabisco buyout.<br />
Politicians were already roused by a frenzy of buyout activity <strong>and</strong> fears of an explosion of<br />
leverage, massive layoffs, community dislocations, <strong>and</strong> by accounts of excessive<br />
multimillion-dollar fees.<br />
As night follows day, the war cry echoed above the Washington monument -- “Something<br />
needs to be done….” Moreover, congressional leaders like Bob Dole, Jim Wright, John<br />
Dingell, Dan Rostenkowski, Lloyd Bentsen <strong>and</strong> Ed Markey, among others, got an earful from<br />
entrenched corporate leaders who were beginning to feel the heat from the raiders or what one<br />
senator memorably referred to as the “fourteen-karat pirates motivated by greed.”<br />
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The heat that was turned on corporations had two aspects. First, companies with depressed<br />
share prices were sitting ducks with top managers looking ripe for unemployment. Second,<br />
the so-called raiders seemed to have a financing advantage in making deals with what Ted<br />
Forstmann has called “the fake wampum of 1980s finance.” An interesting aside here is how<br />
Forstmann broke ranks with the buyout industry over the junk bonds made fashionable by<br />
Drexel’s Mike Milken.<br />
These are days that perhaps we should remember. Congress back in the late ‘80s was<br />
determined to do something – almost anything – about the leveraged deal mania but found<br />
answers in shorter supply than indignation. The creative lobbyists for the Business<br />
Roundtable came up with an argument guaranteed to not only get Congress mad, but also give<br />
them ammunition to do something once <strong>and</strong> for all about LBOs. The argument was that the<br />
U.S. Government – at a time of huge deficits, tax hikes <strong>and</strong> program cutbacks – was providing<br />
gigantic subsidies to buyout artists through a quirk in the tax code. The answer: get rid of the<br />
tax deduction that acquirers enjoyed on the interest they paid on their borrowed funds. Yikes!<br />
This was serious. Takeover activity ground to a halt. Any sensible private equity firm was<br />
laying low on the deal front because they did not want to throw fuel on the fire. But some of<br />
the most important firms became active on another front – government relations. Henry<br />
Kravis, Joe Rice, George Roberts, Ted Forstmann <strong>and</strong> Martin Dubilier – the most fiercely<br />
entrepreneurial <strong>and</strong> anti-political bunch you could ever imagine -- began a coordinated push<br />
to reposition the battle that pitted Main Street against Wall Street. It was the first <strong>and</strong>,<br />
perhaps, last time the industry was unified about anything.<br />
Believe it or not, they organized. They actually funded a campaign to change public<br />
perceptions. And the industry’s top leaders were directly involved. They recognized the<br />
importance of acting in concert to tell a more positive story <strong>and</strong> provide corrective context.<br />
The repositioning involved making the case that buyouts were the driving force for<br />
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constructive change in the U.S. economy at a time when our competitiveness as a nation was<br />
in jeopardy. Remember, it was a time when Japan’s star was still in its ascendancy.<br />
Studies were commissioned. And academics like Michael Jensen made a real impact by<br />
writing about the positive reality of buyouts. Partners at private equity firms testified before<br />
Congress <strong>and</strong> used a blizzard of data that buyouts revitalized undervalued, poorly managed<br />
companies into global competitors. To refute critics, they brought along evidence that<br />
showed that their portfolio companies increased productivity <strong>and</strong> operating profits without<br />
cuts to R&D, capital spending <strong>and</strong> employment.<br />
Importantly, they also challenged the view that buyouts hurt U.S. tax collections, arguing that<br />
the capital gains realized by their firms generated tax revenues well in excess of the tax<br />
revenue associated with an LBO company in any given year. KKR estimated that their<br />
buyouts at that time generated $2 billion more in taxes for the U.S. government because of big<br />
capital gains.<br />
The point is that the political debate was successfully recast away from the extreme position<br />
of Byron Dorgan, a member of the Ways <strong>and</strong> Means Committee, who famously characterized<br />
junk bonds as the “evil engine driving destructive hostile takeovers <strong>and</strong> lining the pockets of<br />
dealmakers” to a debate over the value of buyouts to the economy.<br />
The campaign demonstrated that by changing the tax code Congress risked doing more harm<br />
than good. As one lawmaker observed about the proposed interest deduction cutback: “If<br />
you thought the problem was bad, wait till you see the solution.”<br />
It's not every day that Congress recognizes the error of its ways. At the end of the day, I<br />
believe the evidence that the buyout firms assembled was sufficiently compelling to persuade<br />
lawmakers that buyouts were facilitating the much needed corporate restructuring that would<br />
improve U.S. competitiveness.<br />
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How does this relate to the transparency <strong>and</strong> disclosure debate confronting the private equity<br />
industry today? Well, this could very well become the second threat to unify the industry.<br />
I see some risk that those agitating for common disclosure <strong>and</strong> valuation st<strong>and</strong>ards could<br />
unwittingly become the catalyst for those chilling words “Something needs to be done<br />
about…” The ingredients are clearly there for a politically-driven public relations problem:<br />
broad-based concerns about corporate governance, stories of wide-spread value destruction<br />
causing pain among pensioners, lack of sophistication about the private equity life cycle, <strong>and</strong><br />
a growing media pressure for disclosure that is fuelled, in part, by commercial interests that<br />
eagerly want to publish the information.<br />
It is not too early to begin thinking about repositioning the transparency <strong>and</strong> valuation story or<br />
to otherwise face the consequences.<br />
What are the elements of that repositioning? It has to recognize that: 1) private equity firms<br />
already provide an enormous amount of information about portfolio company performance to<br />
their investors; 2) comparing private equity investments to public equities is deeply flawed;<br />
<strong>and</strong> 3) interim valuations are often very poor indicators of exit values.<br />
Public confidence about what is in the corporate closet is at an all time low. If this confidence<br />
isn’t rebuilt, there will inevitably be more regulatory oversight. There are already signs of<br />
increased regulation in the private equity context– the new Patriot Act’s provision on money<br />
laundering; new privacy rules; the SEC’s investigation into hedge funds – all reflect<br />
incremental oversight.<br />
The broad challenge is repositioning private equity itself. There needs to be more focus on<br />
equity <strong>and</strong> less on private. The essential difference between public <strong>and</strong> private equity is not a<br />
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matter of privacy, but a matter of control. Perhaps we would be better off talking about<br />
“control equity,” instead of "private equity."<br />
Whatever we call it, I believe there are at least 5 compelling themes that could better define<br />
what private equity st<strong>and</strong>s for <strong>and</strong> help build broader public underst<strong>and</strong>ing <strong>and</strong> acceptance of<br />
this poorly understood asset class.<br />
1. Frankness. <strong>Private</strong> equity firms get all the bad news out early. One of the great<br />
advantages of a private equity firm is its willingness to address hard issues <strong>and</strong> make<br />
business decisions that can have negative short-term financial impact. <strong>Private</strong> equity<br />
firms typically insist on tough-minded reviews that can lead to shut-down costs for<br />
exiting poor businesses or geographies, writing off bad inventory, <strong>and</strong>, if necessary,<br />
incurring severance charges for layoffs.<br />
2. Flexibility. Very often, the investment thesis underlying a private equity firm’s<br />
commitment of capital requires a change in the business model of a company. For<br />
example, in a situation I am very familiar with, CD&R’s acquisition of the Allison<br />
Engine Company from General Motors was premised on shifting production away<br />
from military <strong>and</strong> toward commercial markets. The shift required a dramatic change in<br />
Allison’s cost structure in addition to a transition away from highly arcane percent-of-<br />
completion project accounting that made Allison’s financials a nightmare in the first<br />
two years of CD&R's ownership.<br />
3. Long-Term Perspective. Many private equity firms often find major opportunities to<br />
invest in technology to improve productivity. They are willing to accept longer<br />
payoffs. For example, at Alliant Foodservice, a broadline food distributor acquired<br />
from Kraft by CD&R, the company invested more than $25 million dollars in Webbased<br />
technologies that enabled salesmen to see current inventory levels <strong>and</strong> confirm<br />
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sales to customers on a real-time basis. Almost all of these costs were expensed,<br />
depressing earnings.<br />
4. Growth Focus. The days of building value from financial engineering <strong>and</strong> balance<br />
sheet restructuring alone are long gone. <strong>Private</strong> equity firms, in virtually every<br />
investment, are supporting strategies to develop new products, drive sales growth,<br />
fund acquisitions, <strong>and</strong> be catalysts of positive change for their companies.<br />
Investments in growth tend to be a drag on short term operating results, but are<br />
necessary to achieve long-term results.<br />
5. ‘We Serve No Wine Before It’s Time.’ This is an expression often used by Don Gogel<br />
of CD&R <strong>and</strong> it really crystallizes a key point. If a business has grown well <strong>and</strong> there<br />
is a reasonably good market for the sale of the business or a public offering, private<br />
equity firms are usually quick to capitalize on the opening. However, without a<br />
compulsion to sell, firms will hold investments through periods of low acquisition or<br />
public market multiples. As a practical matter, this means that portfolio companies<br />
now in the portfolios of most private equity firms will suffer in the current valuation<br />
environment.<br />
These are powerful themes that are not getting the public traction <strong>and</strong> visibility they deserve.<br />
<strong>Private</strong> equity is often a very messy matter. There's no such thing as a microwavable solution.<br />
It's hard work. It's a commitment to the long-term. This should be better understood.<br />
This is not an argument for non-disclosure. It is more a plea that we need to start shifting the<br />
argument -- not dissimilar to what happened during the interest deduction debate in the '80s --<br />
to promote a better underst<strong>and</strong>ing of how the asset class really works. Otherwise, we should<br />
all steel ourselves for those immortal words: “Something needs to be done about…”<br />
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